Far fewer employers are offering pensions to their employees and that has made IRAs one of the most popular types of accounts among investors. However, one of the most common long-term investment accounts may not be right for everyone. Here are three problems with Roth IRAs that could mean that it makes more sense to use a traditional IRA instead.
1. Income limits
Having too high of an income is a good problem to have, but not if you're hoping to use a Roth IRA to salt away money for retirement.
Unfortunately, Roth IRA's come with income restrictions that limit modified adjusted gross income to $129,000 for single tax filers and $191,000 for married couples. Additionally, investors should know that the amount of money that can be contributed to a Roth IRA begins to phase out for single filers earning more than $114,000 and married couples earning more than $181,000.
Regardless, if your income is above the maximum allowed, you'll be unable to contribute to a Roth IRA. However, investors need not despair. Traditional IRAs do not have income limitations, so as long as you have reportable income and are less than 70.5 years old, you can still contribute to one.
2. Mortality risk
Roth IRA's tax investor's money upfront when it's contributed, but they don't tax withdrawals. That's the opposite of traditional IRAs, which give investors a tax break at the time of their contribution, but do tax withdrawals.
The idea of tax-free withdrawals in your golden years is compelling, but many investors may pass away prior to capturing a Roth IRA's full tax benefit. According to the CDC, roughly 22% of people will pass away prior to age 70 and 11% will pass away prior to age 60.
But investors who don't expect to live long enough to draw down their Roth IRA balance may still decide that Roth IRAs are the best option for transferring wealth to heirs. That's because investors aren't required to take withdrawals from Roth IRA's during their lifetimes, and beneficiaries of Roth IRAs don't owe taxes on withdrawals either. However, heirs may owe estate taxes, so consulting with a tax advisor is important. Regardless, investors considering Roth IRAs should view their life expectancy realistically before deciding whether or not it makes sense to capture an IRA's tax benefit sooner or later.
3. Time value of money
The upfront taxation of Roth IRA contributions may also work against investors over the long haul if it means that tax payments reduce the amount of money that taxpayers could otherwise invest.
For example, a person in the 25% tax bracket that contributes $5,000 per year to a Roth IRA would have to pay $1,250 in taxes on those contributions upfront. If that $1,250 annual tax payment was put to work in an investment with a hypothetical 6.5% annual return for 20 years instead, it could mean an additional $53,933.09 in account value.
However, investors should remember that traditional IRA contributions offer a tax deduction, not a tax credit, so it won't be a one-to-one dollar comparison between the potential tax savings offered by a traditional IRA and the tax payments required by a Roth IRA. Investors should also know that the tax deductibility for investing in a traditional IRA phases out as income increases, so high income earners won't qualify for the deduction.
Regardless, if an investor's income is below those levels, then a traditional IRA contribution could also have the benefit of pushing a taxpayer into a lower tax bracket, or below levels that would allow a taxpayer to qualify for additional tax deductions or tax credits, such as the child tax credit, which could free up even more money to invest for the long run.
Lots to consider
Deciding between a traditional IRA and a Roth IRA is difficult and it's likely that what works best for one investor may not work best for another. In addition to considering these Roth IRA drawbacks, investors also need to consider whether or not they're likely to be in a higher or lower income tax bracket during retirement. If a higher income tax bracket is expected, then a Roth IRA's tax free withdrawals and potential benefits to heirs may be more valuable. However, if a lower income tax bracket is likely in retirement, then a traditional IRA may be best.